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- March 1, 2024
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Preferred Returns Explained: What Every Investor Should Know
Preferred return is a mechanism used by multifamily syndicators to assure investors that they have priority over profits generated by a syndication. It stipulates that a predetermined percentage of profits, such as 8%, is distributed to investors before syndicators receive their share. While the concept appears straightforward, its implementation varies among different syndicators, necessitating a deeper understanding of its nuances.
Different Kinds of Preferred Return
Annual Preferred Return: This is a fixed rate of return that investors receive annually on their investment before any profits are shared with the sponsor. It represents the percentage of profit that investors are entitled to receive annually before profit sharing with the sponsor begins.
Cumulative Preferred Return: In this model, any unpaid preferred returns from previous years are carried forward to subsequent years if not paid out. If an investor does not receive their full preferred return in one year, the unpaid amount is added to the next year’s distribution, creating a cumulative balance that accrues over time.
Non-Cumulative Preferred Return or Hurdle Rate: Here, deficiencies are never paid back. The syndicator doesn’t receive anything until the proposed preferred return (e.g., 8%) is achieved. Some argue that such a return should be called a hurdle rate instead of a preferred return, as it can get quite complicated with waterfall models.
Compounding Preferred Return: Although rare, the concept of compounding preferred return exists. For example, an 8% preferred return on a $100,000 investment would result in an $8,000 payout in the first year, and in the second year, 8% of $108,000 would be distributed.
It’s important to note that syndicators can choose to offer preferred returns using any combination of these strategies. This flexibility allows them to tailor the investment structure to the specific needs and goals of both the investors and the syndication project. However, the complexity of preferred returns can increase quickly, so investors should pay close attention to the exact rules and terms of the preferred return in their investment agreements.
Payment Frequency and Timing
The frequency and timing of preferred return payments can vary depending on the terms of the syndication. Some syndications may pay preferred returns quarterly, while others may do so annually. Additionally, the timing of payments can be influenced by the cash flow of the property and the terms of the operating agreement.
Why Do Syndicators Offer Preferred Return?
Here are some reasons syndicators offer a preferred return:
Attracting Investors: Preferred returns make the investment more appealing by providing a clear, prioritized return, attracting risk-averse investors seeking predictable income.
Aligning Interests: By prioritizing investor returns, preferred returns motivate syndicators to maximize property performance, aligning their interests with those of the investors.
Risk Mitigation: Preferred returns offer a layer of protection for investors, ensuring they receive distributions before the syndicator, reducing investment risk.
Competitive Advantage: Offering preferred returns can differentiate a syndicator’s offering in a crowded market, attracting more capital by providing investor-friendly terms.
Demonstrating Confidence: By offering a preferred return, syndicators signal their confidence in the investment’s ability to generate sufficient returns, building investor trust.
How Do I Know What Preferred Rate My Syndication Has?
The operating agreement of the syndication LLC is the primary legal document that outlines the specifics of the preferred return, including whether it’s defined on an annual or cumulative basis, the calculation method, and the distribution waterfall, which may include hurdle rates and catch-up provisions. However, to gain a comprehensive understanding of the preferred return, investors should also review other related documents such as the Private Placement Memorandum (PPM), which provides detailed information about the investment opportunity, the Subscription Agreement, which outlines the terms of the investment, and Investor Presentations or Offering Memorandums, which highlight key aspects of the investment, including the preferred return structure.
Conclusion
The nuances of preferred return in multifamily syndications can significantly impact both the investors’ returns and the syndicator’s compensation. It’s essential for investors to understand the specific terms of the preferred return in their syndication agreements and how they might affect their investment outcomes.
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